Playing Penny Stock-Like ETFs

Penny stocks are an intriguing segment of the financial markets, but their extreme volatility is generally too much for the average trader to handle. A common trading instinct is to diversify away the company-specific risk by holding a basket of securities. For those new to the markets, products such as exchange-traded funds (ETF) and mutual funds have been created for this exact purpose. These investment vehicles allow investors to gain exposure to a specific group of stocks in return for a reasonable management fee. ETFs and mutual funds are managed by a portfolio manager and they vary in structure and accessibility depending on the product. Unfortunately, at this time there are no ETFs or mutual funds available that use share price of less than $1 as the criteria for creating the portfolio. (For more, check out: Mutual Funds or ETFs: Which is Right for You?)

Luckily for risk-seeking investors, there are ETFs in the market that are dedicated to tracking a basket of companies with small market capitalizations. The most popular product when it comes to gaining exposure to small-cap stocks is the iShares Russell 2000 ETF (IWM). This fund gives investors access to 2,000 small-cap domestic stocks in single position. As of Sept. 25, 2014, the fund had total net assets of just over $24 billion. As you can see from the chart below, this extremely liquid ETF has been trading within a defined uptrend over the better part of five years. Most traders would expect the fund to find significant support near the ascending trendline and for the uptrend to continue until it closes below the support. While the ETF doesn’t technically track penny stocks, it's among the strongest candidates for those investors looking to gain broad exposure to small-cap companies. In terms of sector breakdown, the fund’s top sector weightings are across financial services, technology, consumer discretionary, health care and producer durables.

Investors who want to concentrate on small-cap growth stocks are likely to turn to products such as iShares Russell 2000 Growth ETF (IWO), Vanguard Small-Cap Growth ETF (VBK) and Stonebridge Small-Cap Growth Mutual Fund (SBSGX). These types of funds attempt to invest in a portfolio of small-cap stocks that are expected to grow at an above-average rate relative to the market. As you can see from the chart of the Vanguard Small-Cap Growth ETF, the fund is trading within a similar pattern as IWM. Traders would expect the fund to find support near the ascending trendline. Given the recent weakness it wouldn’t be surprising to see bullish traders wait until they see whether the recent weakness will send the price toward the trendline. The goal for most active traders would be to enter a position as close to the trendline as possible in an attempt to maximize the risk/reward ratio. Traders with an extremely long-term outlook will likely set their stop-loss orders below the 200-week moving average, which is currently trading at $95.34.

Also from iShares is the iShares Russell Microcap Index Fund (IWC), which tracks the bottom 3% of the U.S. stock market based on capitalization. It holds about $500 million and even pays a small dividend (most penny stocks don't).

Traders Turning to Small-Cap Value

In some cases, investors may want to reduce the risk of investing in small-cap stocks by only investing in those with reasonable fundamental rations. In this case, may investors will look to the iShares Russell 2000 Value ETF (IWN), Vanguard Small-Cap Value ETF (VBR) and the T. Rowe Price Small-Cap Value Mutual Fund (PRSVX).

Taking a closer look at the weekly chart of the Vanguard Small-Cap Value ETF, you’ll see that the chart pattern is much for favorable than those mentioned above. The proximity of the price to its 50-week moving average and its ascending trendline suggests that current levels are ideal for bulls looking to take a position. From a technical perspective, the value-oriented small-cap stocks currently offer an ideal risk/reward setup and it wouldn’t’ be surprising to see traders protect their positions by placing stop-loss orders below the combined support of the ascending trendline and its 50-week moving average. (For more, see: Uncovering Hidden Value in Small Cap Stocks.)

Also from Vanguard is the Vanguard Small-Cap Fund (VB). This passive fund is structured to track the the MSCI US Small Cap 1750 Index. Its market cap is north of $4 billion, and like IWC, it pays a modest dividend.

Country-Specific Small-Cap ETFs

For investors looking to invest in small-cap stocks outside of the U.S, it's possible to invest in ETFs such as Market Vectors Brazil Small-Cap ETF (BRF), Market Vectors India Small-Cap ETF (SCIF) or Schwab International Small-Cap ETF (SCHC). Taking a look at the charts of SCIF and SCHC below, you’ll find that it may prove strategic for traders to start looking overseas when it comes to investing in small-cap stocks. Based on the chart of Schwab International Equity ETF, current levels are proving to be an ideal entry point for traders looking to maximize their risk/reward. This group of stocks as been trading within a strong uptrend since July 2012 and traders will expect this trend to continue until the price closes below $31.25.

As one of the primary countries in the BRIC nations, India’s small-cap stocks appear to be well-positioned heading into the last part of 2014. As you can see from the chart, 2014 has been a favorable year for small-cap investors in India and from a technical perspective it appears that this story is likely to continue. The break above the 50-week moving average earlier this year was a clear signal of a long-term shift in the trend. The recent pullback toward the moving average provides an ideal entry point for strategic traders. From a risk management perspective, stop-loss orders will likely be set below the 50-week moving average. Based on the current chart, this could be one of the most profitable trades in 2015 for those astute enough to take notice.

The Bottom Line

While it is currently not possible to invest in exchange traded funds or mutual funds dedicated to penny stocks, it's possible to invest in the small-cap and micro-cap universe based on these products. Given the chart setups across the small-cap universe now could be the time for active traders to take a position. For risk tolerant investors specific interest should be given to the small-cap value stocks and those same types of companies that trade overseas in countries such as India. (For more, see: Winning International Small Caps.)

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